Should I Dollar Cost Average?

NOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action. If you do need help with your investments please contact us.

The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.

Should you use the technique of Dollar Cost Averaging (DCA) when investing money? With almost everything in investing - it depends. As a general rule this method will reduce the risk (volatility) of your new investment but, it may also reduce your gain. We will take an example of a person that has $10,000 to invest.

Usually, DCA is done over a few months but I will do it over 10 years to more clearly show the positive potential of this method of investing. I will compare the results from two different strategies:

1) Lump Sum - you invest all $10,000 in the S&P 500 index on Jan 1, 2001 and do nothing for 10 years.

2) Dollar Cost Average (DCA) over 10 years. Each year you invest $1,000 in the S&P 500 index on Jan 1 and the rest of the money sits as cash and earns no money.

To keep things simple we will ignore all fees and taxes. Below are the returns for 2001 and the next nine years (a total of 10 years).

Year

Return

2001

-11.98%

2002

-22.27%

2003

28.72%

2004

10.82%

2005

4.79%

2006

15.74%

2007

5.46%

2008

-37.22%

2009

27.11%

2010

14.32%

Here are the results (2001-2010) of our two different strategies (Lums Sum is all in on day one and DCA invests $1000 per year and keeps the rest in cash)....

Year End

Lump Sum

DCA Invested

Cash

DCA Total

2001

$8,802

$880

$9,000

$9,880

2002

$6,842

$1,461

$8,000

$9,461

2003

$8,807

$3,168

$7,000

$10,168

2004

$9,760

$4,619

$6,000

$10,619

2005

$10,227

$5,889

$5,000

$10,889

2006

$11,837

$7,973

$4,000

$11,973

2007

$12,483

$9,463

$3,000

$12,463

2008

$7,837

$6,569

$2,000

$8,569

2009

$9,962

$9,620

$1,000

$10,620

2010

$11,388

$12,141

$0

$12,141

It can be very hard so see things in data - So I made a graph....

At the end of 10 years you have more money when you used the DCA method $12,141 vs $11,388 and the green line show less risk (volatility) then the red line. So in this case you have less risk and more money. This is the power of DCA. While you will almost always have less risk using DCA, you will not always end up with more money. The last 10 years are a great example for DCA because the first couple of years were large losses. However, it does not always work out this way. Let us look at another 10 year period. Here are the returns by year 1991-2000.

Year

Return

1991

30.95%

1992

7.60%

1993

10.17%

1994

1.19%

1995

38.02%

1996

23.06%

1997

33.67%

1998

28.73%

1999

21.11%

2000

-9.11%

All but the last year are up years. Here are the results (1991-2000)....

Year End

Lump Sum

DCA Invested

Cash

DCA Total

1991

$13,095

$1,310

$9,000

$10,310

1992

$14,090

$2,485

$8,000

$10,485

1993

$15,523

$3,839

$7,000

$10,839

1994

$15,708

$4,897

$6,000

$10,897

1995

$21,680

$8,139

$5,000

$13,139

1996

$26,679

$11,247

$4,000

$15,247

1997

$35,662

$16,370

$3,000

$19,370

1998

$45,908

$22,360

$2,000

$24,360

1999

$55,600

$28,292

$1,000

$29,292

2000

$50,534

$26,623

$0

$26,623

... and the graph...

Again we see that the DCA method resulted in less risk (smother line). However, in reference to total returns you would have done much, much better just putting the money in all at once $50,534 vs $26,623.

The problem with investing is that you never know in advance if the market is going to go up or down. A financial advisor may be able to help you explore your options and decide which method is best for you given your situation. I know it's tricky and I hope that this helped. If you have question you may put them in the comments or ask me off line.